This blog is a commentary on contemporary business, politics, economics, society, and culture, based on the values of Reason, Rational Self-Interest, and Laissez-Faire Capitalism. Its intellectual foundations are Ayn Rand's philosophy of Objectivism and the theory of the Austrian and British Classical schools of economics as expressed in the writings of Mises, Böhm-Bawerk, Menger, Ricardo, Smith, James and John Stuart Mill, Bastiat, and Hazlitt, and in my own writings.

Thursday, February 02, 2006

Oil, Big Business, and "Monopoly"

A reader of my analysis of the backlash against the profits of big oil companies thinks that one of my statements is “laughable,” namely, my claim that the “oil companies, including Exxon Mobil, have been doing their utmost to increase the supply of oil, including reinvesting a major portion of their profits precisely for that purpose. But time and again, they have been prevented from increasing the supply of oil by the environmental movement and the maze of governmental regulations and prohibitions that it has inspired.” He writes:

Come on! Are we supposed to believe that the brave oil companies are the helpless victims of these environmental laws?! . . . government has supplied to oil companies a means of preventing supply from being increased when they raise their prices - in effect, a monopolistic privilege, in the Rothbardian sense... and we are to believe that oil companies are very angry about this and are trying to increase supplies in spite of it?! ... Environmental laws are just some of the monopolistic privileges that oil companies enjoy, and it is laughable to suppose that they aren't happy with that!

This reader simply ignores all of the repeated efforts of the oil companies to develop ANWR, to increase offshore drilling, to build new refineries and pipelines, and the fact that time and again they have been frustrated in these efforts by the environmental movement. He asserts the conspiratorial, leftist line, apparently endorsed by some prominent libertarians, that government intervention, indeed, socialism and communism, is a capitalist plot, that, if not invented, is at least promoted by big business and the rich for purposes of their further enrichment.He is right, of course, to describe the environmental laws as monopoly legislation. They forcibly restrict the production of oil and thereby make its price higher. But their existence and result are not the responsibility of those who produce oil and thereby add to its supply and make its price lower. I think that this reader and his mentors have probably been unduly influenced by the doctrine of “marginal revenue” and the supposed sensitivity of big business to a consideration of it, as opposed to a consideration of price, in deciding whether or not to expand production.Marginal revenue is the change in total revenue that results from a change in production. It is believed that it follows from the concept of marginal revenue that the larger the share of an industry’s business that a firm accounts for, the less is its incentive to expand its production, because it will have to suffer the resulting reduction in price on its correspondingly larger, already existing output. Thus, for example, if an industry presently produces an output of 100 units of product, which it sells for a price of $10 per unit, its total revenue is $1000. (I’ve kept the numbers as small and simple as possible.) If the industry’s output expanded to, say, 105 units, and the result was a fall in price to $9 per unit (a fall that is necessary in order to find buyers for the additional units), the total revenue of the industry at that point would be only $945, an actual reduction of $55. Its marginal revenue would thus be -$55. From the perspective of the marginal revenue doctrine, if there were only one firm in the industry, producing 100 percent of the industry’s output, its production would never expand in such circumstances, because the result would be lower earnings from the larger volume of production than from the smaller volume of production. I want to point out that even in this, most extreme case, it does not actually follow that the industry’s output would not expand or even that the one firm that presently constitutes the industry would not expand its output. Everything depends on whether or not the production of the additional 5 units is profitable apart from its effect on the earnings from the existing 100 units of output. If, for example, the total cost of producing 5 units to be sold at $9 per unit is less than $45 by enough to provide a competitive rate of profit, those 5 units will be produced and the price will fall. The only question for the firm that presently produces 100 units is whether it wishes to produce 100 units at a price of $9 or 105 units at a price of $9. To whatever extent, it is possible for anyone else, anywhere in the world, to produce those additional 5 units, our firm simply does not have the option of choosing between 100 units at a price of $10 or 105 units at a price of $9. Its only choice is between 100 units at $9 or 105 units at $9.In such circumstances, it’s not at all unreasonable to expect that even our 100 percent supplier firm would be out there attempting to increase its output. Because if it does not increase its output and anyone else does, it ends up with the same lower price, but does so with less volume than it might have had and accordingly earns lower profits than it could have earned. Now the actual fact, of course, is that neither any individual American oil company nor all American oil companies taken together accounts for anything close to 100 percent of the world’s oil output. The United States consumes approximately 25 percent of the world’s oil output, and roughly half of that is now imported. This implies that total oil output in the United States itself is about 12½ percent of global output. The percentage of global output produced by any individual American oil company, such as Exxon Mobil or Chevron, within the United States is far less than that.In terms of our example of price and quantity, the actual fact is that a large American oil company might presently produce on the order of 2, 3, 4, or 5 out of a global oil output of 100. For such a company to be able to increase its own output by an amount equal 1 to 5 percent of the present world oil output, the sheer percentage increase in its own volume would almost certainly substantially outweigh the percentage decline in the world price that its expansion caused. If, for example, Exxon Mobil could go from 5 to 10 in output, while the price declined from $10 to $9, its revenue would rise from $50 to $90, making it vastly more profitable.The more the price of any commodity exceeds the cost of producing additional quantities of it, the more powerful becomes the incentive to expand its supply. This is as true of the price of oil today as of anything else at any other time. All that is required to bring the price of oil down is to get the government and the environmentalists out of the way. The American oil industry would then lead the charge in the expansion of production.